Should You Contribute To Pre-Tax Or Roth 401k?
May 01, 2023For all the efforts that companies undertake to make participating in their retirement plan benefits easy, there’s no simple way to help employees decide whether the money they contribute from their own paychecks should be traditional (also called pre-tax) or Roth (also sometimes called after-tax Roth). The answer can be very nuanced depending on your situation, and for the most part, we won’t know whether we chose correctly until it’s too late. We’ll only really know if we got the answer right when it comes time to withdraw and we actually know our taxable income, current tax brackets, and lifestyle needs.
Since my crystal ball seems to be broken, I’ve attempted to distill the various factors in a way that makes more sense. Keep in mind that many of the factors listed in the chart below are just different ways of saying the same thing, but the intention is to present it in the way that makes the most sense to you.
The biggest factor affecting this decision: taxes
If we all could just know what tax rates will be when we retire and start withdrawing from our retirement savings, along with what our own income will be at that point, this would be a simple choice – if you knew your tax rate would be lower when withdrawing from your retirement account, you’d choose pre-tax and avoid paying taxes on the money today so that you could pay at a lower rate in the future.
On the flip side, if you knew that tax rates would be higher when you’re withdrawing and you’d be paying more in taxes, choose Roth to pay today’s lower rates, then enjoy your savings without tax consequences in the future.
Predicting the future of tax rates
I’m personally making Roth contributions right now in my 401(k) because I believe that we are currently experiencing the lowest tax rates I’ll see in my lifetime. And while I very well may have a lower income in retirement, the tax brackets themselves may be different, so even if I have a lower income, I think I might have a higher tax rate in the future. (keep in mind that I could be wrong about this – reason tells me that tax rates will have to go up in the future, but Congress has surprised us before!)
I like that I can change this strategy at any time. For example, when my husband sold some stock he’d been given as a child for a big capital gain, I switched to pre-tax for the rest of that year in an effort to lower our overall taxable income.
Income limits and the ability to withdraw without taxes
I also like the idea of having investments available to me in retirement that I can liquidate and withdraw without concern for the tax consequences, and my husband and I have too high of a combined income to contribute to Roth IRAs, so I like that the Roth 401(k) doesn’t have an income limit.
Now, there is a way around those income limits using a “back-door” Roth IRA, but that doesn’t work for me because I also have a rather large rollover traditional IRA.
Another consideration: access to the contributions for early retirement
You can’t withdraw Roth 401(k) contributions before 59 1/2 without penalty. However, you can withdraw contributions to a Roth IRA early. If you’re lucky enough to retire before then, you can always roll your Roth 401(k) into a Roth IRA. Then, tap those contributions if necessary, without concern for taxes or early withdrawal penalties. That’s another reason you want to at least have some retirement savings as Roth, regardless of tax rates.
Factors to consider:
| Factor: | Traditional (pre-tax) | Roth (after-tax) |
| You think your taxes are higher today than they’ll be when you withdraw | Makes more sense | Makes less sense |
| You think your taxes are lower today than they’ll be when you withdraw | Makes less sense | Makes more sense |
| You want to avoid required distributions after age 72 | Makes less sense | Makes more sense, as long as you roll to a Roth IRA |
| You think your income tax bracket will be lower when you withdraw | Makes more sense | Makes less sense |
| You think your income tax bracket will be higher when you withdraw | Makes less sense | Makes more sense |
| You need more tax deductions today | Makes more sense | Makes less sense |
| You have a long time until withdrawal and plan to invest aggressively | Makes less sense | Makes more sense |
| You’d like access to your contributions before the traditional retirement age | Doesn’t make sense | Makes sense |
Splitting the difference
If you’re unsure or thinking about it makes your head hurt, you could always split your contributions between the two. In other words, if you’re putting 10% away, you could do 5% pre-tax and 5% Roth. The total $22,500 (plus $7,500 catch-up for over 50) applies as a total to both. However, there’s no rule that you have to put your money into just one bucket or the other at a time.
One more thing to know
No matter your contribution type, any matching dollars or employer contributions will always be pre-tax, per IRS rules. So even if you put all your own contributions into Roth, you’ll still have pre-tax money if you receive any from your job. Now, you may be able to convert those contributions to Roth, depending on plan rules. But if you do that, you’ll have to pay taxes on the amount converted, so plan carefully.